Applying for an auto loan: What you need to know

Young man visiting car dealership and coveting car while wondering how he'll finance it.Image: Young man visiting car dealership and coveting car while wondering how he'll finance it.

In a Nutshell

When you’re on the hunt for a new car, you probably spend a lot of time thinking about make, model and maybe even color. But do you spend enough time thinking about how you’re going to finance it? Where you apply for an auto loan, whether you shop around, and your credit can all affect your auto loan rates and terms.
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While some people spend hours negotiating the purchase price of a new vehicle, finding the right financing can also have a huge impact on your wallet.

If you’re not sure where to start, here are the answers to five questions you might have when you apply for an auto loan.

How should you determine your budget before applying for a loan?

A good way to approach a car loan is to focus on the overall cost of the car — meaning the final price tag, including total number of payments and interest you’ll pay. That way, you’re comparing apples to apples while you shop around. This could make it easier to avoid letting a dealer “pack” your loan with unnecessary features that might fit your monthly budget but could have you paying more in other ways (say with a longer loan term).

If you’re focused on just how much car you can get for the monthly payment you feel you can afford, you may overlook the fact that your loan is for a longer term than you wanted. That longer term may mean a lower monthly payment, but you’ll make more of them — and probably pay more interest — than you would have with a shorter-term loan.

The Consumer Financial Protection Bureau’s auto loan worksheet or Credit Karma’s online car loan calculator may help you decide how much car you can afford to buy.

Where should you apply for an auto loan?

Some car buyers spend hours researching different vehicles online before setting foot on a car lot and taking a test drive. But when it comes to choosing a car loan, the same person might simply go with one of the financing options offered by the dealership.

While getting financing through a dealership can be convenient, you might end up paying a higher interest rate than you would have if you’d gone directly to a lender for a loan. This is because the dealer may add a financing fee on top of the interest rate it offers on your loan.

Where else can you look for auto loans? Online car loans lenders are one place to start, as well as car loans from banks and credit unions.

The best place to get a car loan

What should you consider when comparing auto lenders?

Auto lenders may have different criteria for loan approval, and the terms you receive can vary from one lender to another. Some lenders may require a down payment, and some may offer longer or shorter loan terms than others.

Shopping for the best loan terms can lead to significant savings, even if there’s only a difference of 1 or 2 percentage points in the interest rate. For example, on a $20,000 loan paid off over five years, the difference between a loan with a 4% and 6% annual percentage rate, or APR, could end up being around $1,100.

When comparing lenders, find out what types of loans they offer and if they have any special requirements. Some lenders may only finance new and used car purchases, while others may offer a range of loans, including for a refinance or lease buyout. And some lenders only work with dealers that are affiliated with auto manufacturers, while others work with independent dealers and will finance purchases from private parties.

Options for used-car loans can be tricky, as lenders may have additional requirements regarding the vehicle’s model year, mileage or model. For example, Bank of America issues auto loans for used vehicles, but only if they’re no more than 10 years old, have fewer than 125,000 miles and don’t have a salvage or branded title.

What does preapproval mean?

An auto loan preapproval is a tentative loan offer based on your financial and personal information. Preapproval isn’t a guarantee that you’ll get approved for the loan later, especially if your financial situation changes, but it can help guide your budget.

You can submit several preapproval applications to compare conditional offers from different lenders. You might get preapproved for different loan amounts, loan terms and interest rates.

The preapproval process often takes just a few minutes online. You may need to share your name, contact information, Social Security or tax identification number, mortgage or rent payments, information about your employer and salary, and the make and model of the vehicle if you have a particular one in mind. The lender may check your credit and contact your employer or landlord to verify your information.

Some lenders can preapprove you for a vehicle loan with only a soft credit inquiry, while others will make a hard inquiry, which could ding your credit. Check with the lender before submitting a preapproval application so you’ll know if your credit could be affected.

You may be able to shop around for the best loan without severely affecting your credit — some credit-scoring models view multiple inquiries within a certain time period as just one inquiry.

You can show the preapproval offer to sellers as proof that you’ll likely be able to finance the purchase. A preapproval offer can be a valuable negotiating tool, and you can use it to try to get car dealers to lower the purchase price to meet your preapproved amount or offer better financing terms. Or, it can be your excuse to turn down pricey add-ons that dealerships may try to upsell.

Keep in mind that a preapproval offer will likely have a time limit and may be contingent on the type of vehicle you want to buy and verification of your financial situation. And preapproval doesn’t mean you’re approved for a loan — it just gives you an idea of whether you might be approved and what your rates might be if you are.

How is your credit involved when you apply for an auto loan?

To get the best auto loan rates, you may need excellent credit scores. Some auto lenders approve loans for people with less-than-perfect credit histories, but if you have rough credit you likely won’t get the best loan terms.

It’s a good idea to check your credit scores and reports before you apply for a car loan.

If you have weaker credit, you’ll probably end up with higher interest rates than if you had better credit. You’ll have to decide whether to proceed with getting a car loan, or wait and work to improve your credit first.

Rich Hyde is chief operating officer of Prestige Financial Services, which considers auto loans for people with poor credit. According to Hyde, the lender doesn’t have a minimum credit score requirement. Instead, it looks at the applicant’s entire financial picture, including the applicant’s job and residency stability, income versus monthly payments and total debt, and payment history.

Other lenders may have minimum credit score requirements, and your credit scores could play a larger role in determining what loan terms you may be approved for.

Before applying for a loan, you may want to review your credit reports and dispute any errors that could be affecting your scores. You can check some of your credit scores as well, but keep in mind that auto lenders might use specialized credit scores created for auto lending.

If you already have excellent credit, congratulations! Your good credit may encourage lenders to give you better terms on your car loan. 

The FICO® Auto Score is one such score. It ranges from 250 to 900 and may place greater importance on auto-related past payments, defaults or repossessions than a non-industry-specific score.

What paperwork is involved with the auto loan process?

You may be able to complete the auto loan process over the phone or online, but sometimes you’ll need to send documentation or bring it with you to the dealership when you purchase a vehicle. The required information varies by lender, but typical documentation required with a loan application includes paycheck stubs, proof of residence and a valid driver’s license.

During the final stage of the car-buying process, you may also need to send the purchase agreement, registration, title and lease buyout instructions (if applicable) to the lender. You’ll probably also need proof of auto insurance if you plan to drive the vehicle off the lot.

Bottom line

Whether you’re buying a new set of wheels or planning on refinancing your existing auto loan, taking the time to compare loan options and offers from several lenders can pay off. You could wind up saving a significant amount of money, and getting preapproved ahead of time can help you set a budget and negotiate from a position of strength.

About the author: Louis DeNicola is a personal finance writer and has written for American Express, Discover and Nova Credit. In addition to being a contributing writer at Credit Karma, you can find his work on Business Insider, Cheapi… Read more.